Relativity and Anchoring

by Quan Hoang

Recently I read . The book talks about human irrationalities. It’s a great business related psychology book. I found two ideas relevant to why I like companies with unique products. The two ideas are about relativity and anchoring.

We Always See Things in Relation with Others

The human brain is not equipped with a meter that measures absolute value. So we usually rely on relativity. We look at things around and compare. The picture below demonstrates this idea:

The two middle circles are the same size. But the one surrounded by bigger circles looks smaller than the one surrounded by smaller circles. We have no idea how big a circle is. We just look around and compare.

My personal example is when I looked for a phone recently. I just need a phone to make calls and send messages. I don’t need a smartphone. So, I used a simple, old phone for many years. But recently it broke. I decided to buy a smartphone.

I found a used Google Nexus One on Amazon. It’s in very good condition sold by a highly rated seller. It costs only $100. I was totally impressed with its design at first sight. The specs look great for my need.

But it took me several hours to make a decision. That’s because I compared it with other phones. A bigger screen would be better. A strong battery would be useful. A Quad-core processor is definitely more powerful. Jelly Bean looks cooler than Gingerbread.

Considering my need, I don’t think those phones are different. But I still compared and had the urge to buy the best phone. Finally, I chose Google Nexus One. (I’m quite a rational buyer!) I’m totally satisfied with it although it seems obsolete compared with other phones.

My point is that we always look at things around us in relation with others.

We Rely on an Arbitrary Anchor

Beside relativity, people’s views on things are usually influenced by some anchors. When it comes to price, we don’t know the value. So we tend to rely on some arbitrary benchmark.

One example would be bargaining. In Vietnam, we always bargain when shopping. If the listed price is $50, I would propose $30. If the listed price is $30, I would like to pay $20. I have no idea about value. I just know that it’s worth less than the listed price.

The U.S. version of this example would be a sale. Most people want to buy clothes at 40-50% off the sticker price. They feel they overpay when they pay the full sticker price. I think there are two anchors here. The first anchor is the sticker price. The second is the percent discount we usually get.

Customers Won’t Know If a Product is Expensive without Comparison

We usually use both comparison and an anchor to value something. We look at relative value between things and base our estimates on some basic anchors

I think anchoring causes some misconception about Western Union (WU). When Geoff asked me to analyze WU, my quick answer was “it might be too hard, the service is expensive, and there can be a lot of changes.” But after I looked deeper, I realized it’s not as hard as I thought. The service is not expensive like most people think. Why did I think it’s expensive?

That’s because I always use PayPal to do money transfer with friends. It’s free when I link my PayPal account to my bank account. My experience with PayPal makes me think a money transfer fee should be close to 0%.

It’s different from the perspective of customers. I talked to my cousin who went to work in Taiwan. He uses Western Union to send money home every month. He’s highly satisfied with the service. Customers only think a product is expensive when there’s a much cheaper alternative. Western Union has a small price premium over competitors, but they keep the price competitive. And PayPal is not cheap. PayPal International transfer from bank accounts costs 0.3-3.3% fee and currency conversion. It costs over 3.4% to send from debit card/credit card.

Demand Can Be Manipulated

The idea about anchoring raises a problem in the fundamental rule of supply and demand. There are two curves. The supply curve tells how many units are available at each price. The demand curve tells how many units customers want to buy at each price. The intersection of the two curves indicates market price. The implication of the rule is that supply and demand are two independent forces. But the idea about anchoring says that demand can be easily manipulated by supply.

That’s why I think anchoring and relativity are relevant to the profitability of selling unique products. Companies with unique products can manipulate demand more easily.

Breaking Old Anchors by Being Unique

The example in the book is Starbucks (SBUK). We can be initially anchored to the price of coffee at Dunkin’ Donuts or drinking coffee at home. How did Starbucks break that anchor?

They make themselves unique through store ambience. For example, their shops are fragrant with the smell of roasted beans, which are of higher quality than those at Dunkin Donuts. They have fancy product names for size like Short, Tall, Grande, and Venti, or for coffee like Caffe Americano, Caffee Misto, Macchiato, and Frappuccino. The store experience is so different that the previous anchor is no longer relevant.

If you’re satisfied, you’ll go back to the store. Once you get used to spending $2.20 on a small cup, you may see $3.50 for a medium or $4.15 for a Venti as normal. That’s because you have an anchor price for a small cup. Paying some more for a bigger cup is normal.

I’m amazed at how Zara changes customer behaviors. They introduce thousands of designs every year. But they produce limited copies for each design. They usually sell out a design within 2 weeks. So, customers know that if they don’t buy, the item would be sold out quickly. And they know Zara rarely offers sale. With little time to look for alternatives to these unique items, customers tend to buy immediately (at full price!).

Price is Usually Determined by an Established Anchor

Sometime, price is determined by an established anchor. That’s common in content business. Products are unique, and companies don’t compete on price. If people like a product, they’ll pay a common price. That’s why movies don’t compete on price at movie theaters. That’s why a video game usually costs $40-$60.

The established anchor can also be changed. That’s my concern with Nintendo (NTDOY). They make casual games, not hard-core games like Call of Duty. With the rise of mobile games, people may get used to a new price range for casual games. It’s a big problem for Nintendo if the anchor their games are compared to drops from $40 to $2.

A Good Anchor Improves Perceived Value

Anchoring explains the retail strategy for fashion brands. Companies want to anchor the value of their products as high as possible. Prada wants to open stores next to Gucci. Gucci wants to be next to Prada. They both want to keep themselves far away from Zara while Zara want to be as close to them as possible.

The similar example in Predictably Irrational is when James Assael, the king of pearl, introduced Tahitian black pearls. He bought advertisements in the glossiest of magazines, which put Tahitian black pearls among diamonds, rubies, and emeralds.

On the contrary, I think it’s a stupid idea for Hulu to hope to convert free service customers into using pay service. They anchor customers with a free service. That’s a very hard anchor to break.

The value of free is astronomical. Amazon (AMZN) was able to boost sale when they offer free shipping for order over $25. That’s because customers may want to buy unnecessary books just to get free shipping. But when they offer 10 cent shipping for order over $25, sale didn’t improve at all. So, I would guess the free anchor is very hard to break.

It’s different from giving a free trial. Giving a free trial is a great idea. It doesn’t create an anchor. It actually helps to increase perception value thanks to value of ownership. Basically, when you own something, you value it more. We tend to value things that we own by fear of loss. Customers after the free trial period may value the service more and are more likely to subscribe.

Uniqueness Can Result in Pricing Power

Companies with unique products may also have pricing power. When the products are not anchored to any price, the company can have more freedom to increase price. It’s harder when there are comparable products or substitutes.

That’s why I prefer Games Workshop to giant Mattel (MAT) or Hasbro (HAS).

Hasbro and Mattel produce toys for the mass market. Their pricing power is limited. Each toy is unique but it’s still a toy. Toys as a category have to compete with other entertainment products. The price of other products is out of Hasbro’s and Mattel’s control. And people can compare those products with toys.

Also, there’s an anchor for toy prices. The price sweet spot is from $10 to $20. Hasbro saw volume decline when they increased price from $19.99 to $21.99. I think this has something to do with the way people buy toys. Parents and grandparents usually buy toys on holiday. They tend to buy several gifts at a time. A family with 2 kids may want to buy 5 toys. They have a budget for toys because they also buy gifts for their spouse or friends. So, they may not want to spend over $20 for a toy.

Games Workshop is another story. Those unfamiliar with Games Workshop should read the discussion about the company at Interactive Investor. Games Workshops produces hobby products instead of toys. People are willing to spend a lot of money on a hobby. I don’t think that people dedicate time and money to more than one hobby. Even if they do, Warhammer is cheaper than most hobbies. By positioning Warhammer as a hobby, Games Workshop aligns pieces of plastic with hobby products like golf clubs. People don’t value a hobby product by how much it costs to produce. They value it by the enjoyment they get. So, Game Workshop increases price every June. Hobbyists complain but they still buy and enjoy.

So, I think relativity and anchoring are powerful ideas in learning customer behaviors. I think companies with unique products can have pricing power thanks to the lack of comparison and price anchor. They can also improve value perception by getting closer to other high value unique products. And when there’s no comparison, companies just need to maximize the price they can sell, and make sure that customers enjoy the products.